By way of background, the "Fifth Protocol" is a
protocol to amend the Canada-U.S. Tax Convention (the
"Treaty"). It was signed by representatives of both
countries on September 21, 2007. While Canada has concluded all of
its internal steps necessary to ratify the Protocol, the U.S. must
still do so. As part of the American process, the U.S. Joint
Committee on Taxation furnished the Senate Committee on Foreign
Relations with its Explanation (the "JC Explanation") on
July 8, 2008 and on July 10, 2008 the U.S. Department of the
Treasury released its Technical Explanation of the Fifth Protocol
(the "Technical Explanation"). Also on July 10, 2008, the
Minister of Finance (Canada) indicated Canada's agreement with
the Technical Explanation.
Both the Technical Explanation and the JC Explanation go into
some detail regarding "hybrid entities", which will be of
concern to those who invest in Canada from or through the U.S.
These hybrid entities are treated as fiscally transparent entities
pursuant to the tax laws of the payment recipient's country and
as separately taxed entities pursuant to the tax laws of the
country in which the hybrid entity is resident. For example,
currently, U.S. limited liability companies ("LLCs") are
fiscally transparent in America but are treated and taxed as
regular corporations in Canada. Similarly, Canadian unlimited
liability companies ("ULCs") are treated as corporations
in Canada but recognized as fiscally transparent in America if they
"check the box" to be treated as disregarded entities for
purposes of U.S. tax.
It was thought that the Protocol would regularize the treatment
of LLCs and ULCs under the Treaty. However it ended up creating
further anomalies and there was some hope that the Technical
Explanation might provide additional clarification. Unfortunately a
number of issues which had been raised with respect to the Protocol
were not addressed, especially as regards nonabusive cross-border
Historically, the Canada Revenue Agency ("CRA")'s
position has been that an American LLC, which is a disregarded
entity for U.S. tax purposes, cannot therefore be considered as
resident in the U.S. and be entitled to the benefits of the Treaty.
The Protocol contains a lookthrough rule which will treat Canadian
income, dividends and interest as being earned by the members of
the LLC. If the members are U.S. residents, they will be entitled
to reduced Treaty withholding rates.
In trying to apply this aspect of the Protocol, certain
commentators had raised concerns about the "same treatment
test", about S-Corporation withholding tax rates, about the
continued tax filing obligations of the LLC (notwithstanding that
its members derive the income), about the determination of
"beneficial ownership" regarding interest and dividends,
and about the limitation of benefits rules. These commentators have
noted that the Technical Explanation did not fully address some of
the uncertainty challenges in the Protocol.
The Technical Explanation also failed to meet clarification
expectations in the area of ULCs. For example, the Technical
Explanation confirmed that subparagraph 7(b) of Article IV of the
Protocol would apply to deny Treaty protection to dividends,
interest payments and royalty payments by a ULC to a U.S.
shareholder where the ULC is a disregarded entity for U.S.
purposes, but did not address the case of interest and royalty
payments where a Canadian corporation is considered by U.S. law to
be a partnership. Most importantly, the Technical Explanation was
silent, notwithstanding that the JC Explanation acknowledged the
benign aspect of certain ULCs, on whether the Protocol's
anti-hybrid provisions would apply to non-abusive structures
involving ULCs where "double dipping" on tax deductions
was not the reason for the cross-border structure.
If the Protocol is fully ratified by the U.S. in 2008, it will
become effective on January 1, 2010. A number of existing
cross-border structures will have to be examined closely before
then to avoid the potential for double taxation.
* Pleading the 5th : U.S. Department of Treasury
Disappoints on Cross-Border Hybrids
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